Rising inflation and interest rates in Western economies are reversing a mostly continuous 35 year period of benign conditions in the financial markets. Between 1990 and 2020 inflation remained subdued, and interest rates were progressively lowered. In the US interest rates fell from 8 per cent in 1990 to close to zero in 2020-2021. They are now over 5 per cent and, with inflation running at 8 per cent, are headed higher. Long bond yields are approaching 8 per cent. In Australia, inflation is over 6 per cent after a long period of price quiescence. Interest rates, which were over 10 per cent in 1990, fell to close to zero in 2020. They have since rebounded to 4 per cent.
The cost of capital, in other words, is back. It means the games played with debt and money creation – in Australia these have been most evident in a once-in-a-century bubble in house prices – are becoming riskier. In one sense, it is a return to a more normal period when risk taking is, well, risky. But in another way it is pointing to some strange and unfamiliar challenges, not least because the world economy is groaning under a massive debt load: over 300 per cent of global GDP. If interest rates return to more typical levels, that debt becomes unpayable.
Western leaders have repeatedly asserted since 2020, as if they were all reading from the same script, that the world economy needs to undergo a Great Reset. Exactly what was meant by that was opaque, couched in language of corporatism and management jargon, which obfuscates as much as it communicates. We do, nevertheless, seem to be headed for a reset – just not the one imagined and not like anything seen before.
The most expected outcome of unpayable debt levels, in an environment of rising interest rates, is some sort of deep and sustained recession, perhaps even Depression. If the latter, it connotes images of grinding privation for a sizable portion of the population, where even necessities become unaffordable.
That will not happen. We will not return to the 1930s or anything like it. Relentless, long term improvements in efficiency in primary industry, especially food and secondary industry, have completely changed the shape of economic life. Indeed, before 2020 many industry sectors were suffering from extreme oversupply. The enabler was the combination of computer technology and the internet which created what has been described as post-industrial society: a society that has transitioned from an economy mainly of goods to an economy mainly of services. To give some idea of how extreme this shift has become, in Western economies half of people’s waking lives are now devoted to entertainment.
The reset is instead likely to be a huge shift in what households spend their money on. Food is likely to remain plentiful due to massive efficiency and international supply chain advances, although prices may rise significantly, forcing consumers to make unfamiliar choices. Clothing is also in oversupply because of the internationalisation of production, much of it ethically questionable.
'Should interest rates continue rising, the financial stress will spread to mortgage holders. We may be transitioning to a society of debt slaves and the debt free.'
Infrastructure, which can be described as ‘sunk wealth’ – that is, the opposite of ‘sunk cost’, an investment that can’t be recovered – will not significantly change. In developed economies most of what is necessary tends to have been built a long time ago, and the main challenge is maintenance. Infrastructure’s value is not represented in conventional economic statistics, which are more about fast moving transactions, but it is critically important to quality of life.
The big financial shocks are instead likely to come in two essential areas: shelter and energy. In Australia, shelter, housing, has become, due in large part to the combination of low interest rates and negative gearing tax advantages, as much an object of financial speculation as the various things associated with ‘having a roof over one’s head.’ It has led to massive distortions that are likely to continue causing instability for decades. The rental affordability crisis in capital cities is the latest version of these upheavals as investors increase rents to try to stop losing too much money (negative gearing is bizarrely a strategy based on making losses). Should interest rates continue rising, the financial stress will spread to mortgage holders. We may be transitioning to a society of debt slaves and the debt free.
Changing the energy grid to accommodate net zero ambitions will cause even bigger disruptions. Goldman Sachs, the Bank of America and the United Nations have estimated that getting to net zero will cost somewhere between $US80 and $US150 trillion between now and 2050. For the investment community it looks like a bonanza. But who will pay that extraordinary amount? Consumers, of course, and it will mean that a much larger portion of household income will go towards just turning the lights on. The implications are yet to be fully understood, but, if pursued to their logical end, it will redefine what we mean by the cost of living.
It is always hard to separate actual economic reality from financial measures. Gold bugs, people who think we should go back to a monetary system backed by gold, are fond of observing that in 1972, when the US went off the gold standard, one dollar equalled 1000 milligrams of gold. Now, one dollar is worth 10 milligrams, a 99 per cent drop in value.
They claim that shows just how much money has been devalued in our current system of ‘fiat currency’: money created through government edict, or fiat. But if that were really true then most of us would have starved to death. Monetary measures can be very misleading. To get a sense of where things are going it is better to start, not with the money patterns, but the basics of life.
David James is the managing editor of personalsuperinvestor.com.au. He has a PhD in English literature and is author of the musical comedy The Bard Bites Back, which is about Shakespeare's ghost.
Main image: (Getty images)